Overview of Financial 1-1. Statement Analysis

Transcription

1 Overview of Financial 1-1 Statement Analysis

2 1-2 Financial Statement Analysis Financial Statement Analysis is an integral and important part of the business analysis. Business analysis? Process of evaluating a company s economic prospects and risks. The purpose is to improve business decisions.

4 1-4 Business Analysis These business decisions extend to equity and debt valuation, credit risk assessment, earnings predictions, audit testing, compensation negotiations, and countless other decisions. Business analysis aids in making informed decisions by helping structure the decision task through an evaluation of a company s business environment, its strategies, and its financial position and performance.

5 Component Processes of Business Analysis 1-5

6 Industry Analysis 1-6

7 1-7 Strategic Analysis Encompass (includes) evaluation of: Business decision Success in achieving competitive advantage This includes assessing a company s expected strategic responses to its business environment and the impact of these responses on its future success and growth. Strategy analysis requires scrutiny of a company s competitive strategy for its product mix and cost structure.

17 1-17 Investing Activities Operating assets: Investments in land, buildings, equipment, legal rights (patents, licenses, copyrights), inventories, human capital, information systems, and similar assets are for the purpose of conducting the company s business operations. Operating activities are a company s primary source of earnings. Earnings reflect a company s success in buying from input markets and selling in output markets. Analysis of earnings figures, and their component parts, reflects a company s success in efficiently and effectively managing business activities. Financial assets: invest excess cash in securities such as other companies 'equity stock, corporate and government bonds, and money market funds. Current assets: short-term Non-current assets: long-term

21 1-21 Credit Analysis Liquidity ratios: Current ratio: measures current assets available to satisfy current liabilities. Current ratio = Acid-test ratio: a more stringent test of short-term liquidity, uses only the most liquid current assets: cash, short-term investments, and accounts receivable. Acid-test ratio =

22 1-22

23 Analysis and Interpretation: Mixon's short-term liquidity position has weakened over this two-year period. Both the current and acid-test ratios show declining trends. Although we do not have information about the nature of the company's business, the acid-test ratio shift from 1.7 to 1 down to 0.9 to 1 and the current ratio shift from 2.9 to 1 down to 1.9 to 1 indicate a potential liquidity problem. Still, we must recognize that industry standards may show that the 2004 ratios were too high (instead of 2006 ratios as too low). 1-23

37 1-37 Exercise Sales 100.0% 100.0% Cost of goods sold Gross profit 34.0% 47.6% Operating expenses Net income 13.0% 28.2% Analysis and Interpretation: This situation appears to be unfavorable. Both cost of goods sold and operating expenses are taking a larger percent of each sales dollar in year 2006 compared to the prior year. Also, even though sales volume increased, net income both decreased in absolute terms and declined to only 13.0% of sales as compared to 28.2% in the year before.

38 1-38 Exercise Express the Mixon Company s balance sheets in common-size percents. (Round to the nearest one-tenth of a percent.)

44 1-44 Management s Discussion & Analysis (MD&A) A portion of an organization's annual report that is written for shareholders in which management explains how the company performed the past year and projections for the coming year. The report also highlights other aspects of the organization.

45 1-45 Management Report The purposes of this report are to reinforce: 1. senior management's responsibilities for the company s financial and internal control system and 2. the shared roles of management, directors, and the auditor in preparing financial statements.

46 1-46 Auditor report An external auditor is an independent certified public accountant hired by management to provide an opinion on whether or not the company s financial statements are prepared in conformity with generally accepted accounting principles. Financial statement analysis requires a review of the auditor s report to ascertain whether the company received an unqualified opinion. Anything less than an unqualified opinion increases the risk of analysis.

49 1-49 Proxy Statement Shareholder votes are solicited for the election of directors and for corporate actions such as mergers, acquisitions, and authorization of securities. A proxy is a means whereby a shareholder authorizes another person to actor him or her at a meeting of shareholders. A proxy statement contains information necessary for shareholders in voting on matters for which the proxy is solicited. Proxy statements contain a wealth of information regarding a company including the identity of shareholders owning 5% or more of outstanding shares, biographical information on the board of directors, compensation arrangements with officers and directors, employee benefit plans, and certain transactions with officers and directors. Proxy statements are not typically part of the annual report.

53 1-53 Analysis Preview Common-Size Analysis In analyzing a balance sheet: It is common to express total assets (or liabilities plus equity) as 100%. In analyzing an income statement: Sales are often set at 100% with the remaining income statement accounts expressed as a percentage of sales.

54 Analysis Preview 1-54

55 Analysis Preview 1-55

56 1-56 Analysis Preview Purpose : Output: Ratio Analysis Evaluate relation between two or more economically important items (one starting point for further analysis) Mathematical expression of relation between two or more items Cautions: Prior Accounting analysis is important Interpretation is key

57 1-57 Analysis Preview Purpose: Estimate intrinsic value of a Basis: company (or stock) Present value theory (time value of money) Valuation Valuation - an important goal of many types of business analysis

58 1-58 Analysis Preview Debt (Bond) Valuation B t is the value of the bond at time t I t +n is the interest payment in period t+n F is the principal payment (usually the debt s face value) r is the investor s required interest rate (yield to maturity)

59 1-59 Analysis Preview Annuity & its Present Value (PV) An annuity is a series of payments made at fixed intervals of time.

69 1-69 Analysis Preview Equity Valuation - Residual Income Model BVt is the book value at the end of period t Ri t+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RI t = NI t - (k x BV t-1 )] k is the cost of capital E refers to an expectation

70 1-70

71 1-71 Analysis in an Efficient Market Three assumed forms of market efficiency Weak Form - prices reflect information in past prices Semi-strong - prices reflect all public Form information Strong Form - prices reflect all public and private information

72 1-72 Analysis in an Efficient Market EMH assumes the existence of competent and well-informed analysts using tools of analysis like those described in this book. It also assumes analysts are continually evaluating and acting on the stream of information entering the marketplace. Extreme proponents of EMH (Efficient Market Hypothesis) claim that if all information is instantly reflected in prices, attempts to reap consistent rewards through financial statement analysis is futile. This extreme position presents a paradox. On one hand, financial statement analysts are assumed capable of keeping markets efficient, yet these same analysts are assumed as unable to earn excess returns from their efforts. Moreover, if analysts presume their efforts in this regard are futile, the efficiency of the market ceases.

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